September 2011
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Public Pensions, Broken Promises
As we inch closer to our “golden years,” most of us imagine retiring to a warm climate near a beach, taking leisurely trips to distant places, or spending quality time with our grandchildren. But some public workers who were counting on their pensions to make those dreams come true may have a rude awakening.
For decades, many state and local governments were able to sidestep their pension funding obligations in part because of significant differences between public pension regulations and those governing private industry. The Employee Retirement Income Security Act (ERISA), a federal law passed in 1974 to establish minimum standards for retirement benefit plans in the private sector, does not apply to public pension plans. Generally, most public retirement plans assume a 7% to 8% return on their investments, even though most economists argue that 3% to 5% is more realistic. Consequently, many state and local governments shortchanged their pension funds during good times as well as bad, and retirement investment funds, like all other investments, are affected by market volatility. It's no surprise, therefore, that the ongoing financial crisis has exacerbated the problem of public pension underfunding.
Public workers are coming to realize that their pensions are no longer off limits to budget cuts.
According to an August New York Times article, “Faltering Rhode Island City Tests Vows to Pensioners” (www.nytimes.com/2011/08/13/us/13bankruptcy.html), Central Falls filed for bankruptcy last month and sought to reduce the pension benefits of its retired police officers, firefighters, and other workers “by as much as half,” to address its budget woes. And Central Falls isn't alone in this mess.
As the financial crisis has lingered, beleaguered states and municipalities have begun to examine whether there might be loopholes that would allow them to reduce the pensions of current workers. The article, however, also went on to say that investors who purchased the city's bonds might be protected from losses by a recently enacted law that was intended to ensure that the bondholders “would be paid in full, even in bankruptcy.” So what explains the discrepancy in the way workers are treated as compared to bondholders?
Who Should Bear the Risk of Loss?
The situation pits Central Falls' workers, who earned their retirement benefits over many years, against its bondholders, who helped to finance the city's operations. Federal bankruptcy law gives equal standing to pensioners and general obligation bondholders, both of whom are at the bottom of the list as unsecured creditors.
Workers?
Setting aside for a moment the argument that defined benefit plans are too costly to be financed on the backs of taxpayers, can governments that are charged with protecting their citizens ethically—or even legally—change the rules in the middle of the game for current employees, who may have been recruited with the promise of a pension upon retirement? Governments shouldn't be allowed to use a bait-and-switch strategy by, when the bills come due, simply changing the rules. To make matters worse, Central Falls—as have many other state and local governments—didn't enroll all of its workers in Social Security, as a cost-cutting measure. This removes yet another retirement safety net for these employees.
Bondholders?
Most investors expect that there will be some risk of loss associated with their investment. So why then did Central Falls seek to indemnify its bondholders from losses resulting from the city's bankruptcy while letting public workers bear the brunt of its fiscal problems? The answer is simple: The city was seeking to protect its future borrowing prospects. officials were concerned that interest rates on future loans from prospective lenders would be negatively impacted as a result of a default. Makes sense.
It seems as though Central Falls officials are caught between the proverbial rock and a hard place—and others are waiting and watching to see how this plays out. Public workers are coming to realize that their pensions are no longer off limits to budget cuts in our new fiscal environment. I suppose we can add public pensions to the growing list of governments' broken promises.
As always, I welcome your comments.